Selection Dilemma: Large vs Mid vs Small
This Article was originally published in The Global Analyst
“Midcaps and Smalls caps have bounced back smartly!” screams economic news headlines. Of course they did, but so did large caps. Also, the bounce back happened after a steep fall making us wonder as to the source of excitement. Though covid started end of December, it is not until march that the full impact of its devastation rattled financial markets globally and in India. To be precise, 23rd March 2020 marks as the date when markets hit a super low all over the world including India. The fall was quick and deep. But what surprised many is the speed with which the rebound happened leading to the headline scream referred above. It is a sort of a V-shaped journey where losses were recouped more than making profits. In effect, all the three indices (large cap, mid cap and small cap) are still under the water as of 19th August 2020.
This raises a deeper question “Should we invest in mid-caps and small caps at all”. The traditional argument is that the upside to investing in mid-caps and small caps is way higher than large caps. Today’s Reliance and Infosys were once a small cap turned mid cap turned large cap. Fair enough. This is true if only we can spot a Reliance or Infosys well in advance when they were swimming in the small and mid-cap space. Let us examine the stock universe from various angles and analyze the question.
1. Performance: While looking at the risk-adjusted performance of these asset classes, it is clearly evident that mid-caps and small caps plot very inferiorly in the graph. In other words, when we invest in mid and small caps, we take more risk for less return. (Should it not be otherwise?). While we may not be averse to taking higher risk (as this is clearly the bet) one should be compensated for this through higher returns. Otherwise, it defies the very logic of investments.
2. Size of the Universe: Polarization is a major issue not just with Indian stocks but with almost all markets. In the context of S&P500, there is a joke that it is comprised of two indices i.e., S&P5 and S&P495 where the former constitutes the majority. The same applies to Indian stocks as well.
Note: As per SEBI circular in 2017, top 100 companies are classified as Large Cap; next 150 are classified as Mid Cap and rest are all small cap
In the total universe of 3840 stocks under our study, we can see how lop sided this distribution is in terms of large, mid and small. While large cap accounts for 74% of total market cap, it accounts only for 3% of stocks. Conversely, the small cap accounts for 93% of companies with a 10% share in market cap. The skew is even more evident when we look at the average market cap across these three segments. Stock picking within a pot of 100 or 200 stocks improves the odds to spot winners than looking at thousands of companies. While it is true that there are many hidden gems in the large company universe of small caps, it is just humanely not possible to analyze so many of them to find the gems.
3. Operational Metrics: Large caps tend to be dominating due to their size and hence command market leadership in their respective industries. Due to this reason, they command pricing power and enjoy better margins and cash flows. It is also due to this reason, they command higher valuation in terms of P/E and P/B. More importantly they have better operational metrics like operating cash flows, free cash flows, better interest cover and better dividend yield, to name a few. Also their return on capital employed, Return on Equity and other return measures compare well for large caps compared to mid and small caps.
4. Drawdowns: This is normally an overlooked risk metric that I place a lot of importance. A drawdown is defined as the percentage fall from index peak to index trough and how long it took to recover from the bottom. The index peak for Nifty 50 happened on 14 Jan 2020 with the index hitting 12,362 and fell to a trough of 7,610 on 23rd March 2020 implying a 38% fall. In terms of days, that is only 69 days. However, when we look at the same data for mid-caps and small caps, the fall has been steeper and long-lasting (800days). In other words, when mid-caps and small caps go down, they stay there longer and one may have to wait it out to recover the capital.
5. Sector Representation: While financials dominate all the three segments, we can notice that large caps are dominated by high margin industries like technology and consumer non-cyclicals while mid-caps and small caps suffer from low margin industries like Basic materials, Industrials, Construction and Chemicals. This resonates with our earlier observations about market leadership and pricing power. Also, the domination of top 5 sectors is noticeable in large caps compared to small caps which makes stock picking that much more easier for the large cap segment.
6. Liquidity: Nearly 75% of total value traded is accounted by large caps with mid-caps accounting for 20% and small caps 5%. The low liquidity can actually increase the cost of trading (through higher bid-ask spreads) and can be the reason why they plot inferior on the risk-return graph. Lack of liquidity will drive away large funds as it renders both buying and selling large quantities difficult. Derivatives support is also generally available only for liquid counters and hence hedging mid cap and small cap risk at a stock and index level is also rendered difficult.
I deliberately avoided a commentary on valuation metrics like price to earnings and price to book. This is due to the fact that presently with earnings suffering a steep fall and markets recovering faster than anticipated, an increase in the numerator (price) and a decrease in the denominator (earnings) will definitely result in steeper p/e. In due course this will be corrected either by a price fall (more likely) or an earnings catchup (less likely) or both. As this is a moving target, I choose not to flag this as a metric for evaluation.
Individual investors are better off taking no exposure to small cap and mid-caps as per this research. Institutional investors and high net worth can consider active management of mid-caps but should realize that it may consume more research time. Mid-caps and small caps can therefore lend itself to more quantitative application which can minimize or avoid time-consuming human research.